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Real Options With Priced Regime-Switching Risk

Listed author(s):
  • JOHN DRIFFILL

    ()

    (School of Economics, Mathematics and Statistics, Birkbeck College, Malet Street, London WC1E 7HX, UK)

  • TURALAY KENC

    ()

    (Central Bank of Turkey, Istiklal Caddesi 10, Ulus. 06100 Ankara, Turkey)

  • MARTIN SOLA

    ()

    (Universidad Torcuato Di Tella and Birkbeck College, School of Economics, Mathematics and Statistics, Birkbeck College, Malet Street, London WC1E 7HX, UK)

We develop a model of regime-switching risk premia as well as regime-dependent factor risk premia to price real options. The model incorporates the observation that the underlying risky income streams of real options are subject to discrete shifts over time as well as random changes. The presence of discrete shifts is due to systematic and unsystematic risk associated with changes in business cycles or in economic policy regimes or events such as takeovers, major changes in business plans. We analyze the impact of regime-switching behavior on the valuation of projects and investment opportunities. We find that accounting for Markov switching risk results in a delay in the expected timing of the investment while the regime-specific factor risk premia make the possibility of a regime shift more pronounced.

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File URL: http://www.worldscientific.com/doi/abs/10.1142/S0219024913500283
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Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance (IJTAF).

Volume (Year): 16 (2013)
Issue (Month): 05 ()
Pages: 1-30

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Handle: RePEc:wsi:ijtafx:v:16:y:2013:i:05:n:s0219024913500283
DOI: 10.1142/S0219024913500283
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